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Due to the overwhelmingly positive response to my last article about my involvement with the
WSU Foundation Board of Trustees, I thought it would be good to cover some of the main topics
that I would like to see in a financial literacy course someday.
I know for some of us, you’d rather watch paint dry than learn about this, but these are some of
the most basic financial areas that just about every person is currently dealing with, or is going to
deal with, at some point in their life.
We all have heard of interest, but what is the difference between Simple Interest and Compound
Interest? The answer is quite simple (pun intended) but it can also be huge in the long run. Simple Interest means that the interest earned (or owed) is based on the original balance. When
it comes to investing, let’s say I have a $100,000 bond earning 5% interest. That bond will pay me a
fixed value of $5,000 per year in interest until its maturity date because it’s always 5% of my
original $100,000. Very basic, hence the name “simple interest”.
Simple interest can also apply to loans. For example, many people have a Home Equity Line of
Credit (HELOC) in addition to their first mortgage. Typically, a HELOC is a 20 year loan with the
first 10 years being interest‐only. That means that if I have a $100,000 balance on my HELOC at
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3.25%, my monthly payment is only ~$271 ($100,000 x 3.25% / 12). Since I’m just paying the interest
owed and no principal, this is a simple interest loan.
Note: If you have a HELOC that is approaching the 10 year mark, I highly recommend you review
your loan document to see when it starts to amortize. Most HELOCs have a 10 year amortization
schedule starting in the 11th year. Continuing with the example above, assuming interest rates stay
roughly the same, this means your monthly payment would go from ~$271 to ~$977 because you
are now starting to pay down the principal. See below for more information on how amortization
works.
Compound Interest, on the other hand, gets a little more complicated because you are now
calculating the interest earned (or owed) on a fluctuating balance. Using the example above,
instead of it always being 5% of the original $100,000, the $5,000 is reinvested making the new
balance $105,000. That means the next year I receive 5% of $105,000 which would be $5,250. Then,
the next year my balance would be $110,250 earning 5% and so on. You get the idea. With
compound interest you are reinvesting your earnings and the interest you receive is calculated
based upon the new balance.
Here’s a fun math question to demonstrate the power of compound interest:
Would you rather receive a $100 bill every day for 30 days or a penny a day that doubles every day
for 30 days? For those of you that took the $100 bills for 30 days, you received $3,000 but for those
of you who were “penny wise” received $5,368,709.12.1 What I find amazing is that on day 29 it was
half that ($2,684,354.56).1 You can see why Einstein said compound interest was the most
powerful force on Earth.
Now that we’ve talked about how much fun compound interest can be on the upside, let’s talk
about the realities on the downside because the same rules apply. The best way to explain this is
through another example, so here it goes: How much did I make if I earned 50% last year but then
lost 30% this year? The answer is 5%. To demonstrate, suppose I start with $100,000 and make
50%. I now have $150,000 but then I lose 30% ($45,000) of the bigger number ($150,000). I have
$105,000 in the end. As I like to say, 50% minus 30% is 5% in a compound interest world. This is
why CWM emphasizes the downside protection in our strategies so strongly; making it is a lot
easier than keeping it!
While there are several common areas that use amortization, since we are talking about everyday
finance, we are referring to amortization as it applies to mortgages, car loans, and student loans.
The best concise definition of amortization in my opinion is “The repayment of principal from
scheduled mortgage payments that exceed the interest due.”2 I know that sounds a bit Greek but if
you look at the table below I think you’ll understand.
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Click to Enlarge
Source: The Free Dictionary2
As you can see in the chart, as principal gets paid down the amount of interest owed goes down
and therefore, if I’m making a fixed payment every month, more of my payment goes towards the
principal balance the further along I am.
If you have any everyday financial topics you’d like us to explore, or questions about this article,
please don’t hesitate to call us at (425)778‐6160 or (800) 268‐2440, or email Brian. Brian J. Lockett, CFP®
VP, Wealth Manager
[email protected]
Sources:
. https://sites.google.com/site/teambarsite/ourexcitement
. http://financial‐dictionary.thefreedictionary.com/amortization
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investment or to participate in any trading strategy. Information is based on sources believed to be reliable; however, their accuracy or
completeness cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax, legal or investment
planning advice as individual situations will vary. For specific advice about your situation, please consult with a financial professional. Past
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